Local Government Pension Scheme

1. Local Government Pension Scheme Actuarial Mathematics Workshop 2013 Research opportunities

2. Introduction Local Government Pension Scheme

3. LGPS overview - some facts and figures • Established by the Superannuation Act 1972 • Open to employees working in local government, those working for participating employers and some councillors • A multi-employer funded defined benefits pension scheme • Comprises 101 regional funds in the UK • Approx 10,000 employers and growing (e.g. academies) • Approx 1.6 million contributing members • Benefit payments in 2011-2012 were approx £7.5 billion • Assets end of March 2012 were approx £148 billion • 4th largest DB pension scheme in the world

4. LGPS overview – benefit structure • Pre April 2008 final salary (1/80th pension + 3/80th cash) • Post April 2008 final salary (1/60th pension + commutation) • Post April 2014 CARE (1/49th pension + commutation) • Contributory • Complex legacy protections • Highly political

5. LGPS overview – what do actuaries do? • Triennial funding valuations to recommend contribution rates for existing employers • Provision of strategic investment advice (stochastic modelling) • Risk assessments and contribution rates for new employers • Cessation valuations for exiting employers • Financial reporting for individual employers under FRS17 and IAS19 (now represents more than half of all activity)

6. LGPS overview – actuarial capacity issues • Only 4 actuarial firms have any significant presence in the LGPS marketplace • Considered low margin business by most proprietary consulting firms • Regarded as highly specialist • Significant capacity problems • Currently low levels of investment in systems and staff particularly with general decline in DB pension schemes • Fund Actuaries also carry out work for employers – significant potential for conflicts of interest

7. Introducing PensionsWatch

8. PensionsWatch • Seven directors and two freelance consultants (actuarial, LGPS, IT, legal, business skills) • Innovative new service aimed at providing low-cost independent actuarial advice directly to LGPS employers • Core offering is a package comprising financial reporting and related monitoring of funding measures, outsourcing advice and general actuarial support • Unique selling point is a web-based service delivery through our NeXtStep platform • Our objective is to significantly expand market capacity, bringing affordable and independent actuarial services within the reach of ordinary LGPS employers

9. Research opportunities Selection criteria

10. Selection criteria • Suited to a mathematical or statistical treatment • Provides solutions needed by industry • Must be capable of practical application • Provides solutions that are of commercial value to consulting actuarial firms, audit firms, standards setters and regulatory bodies • OR that serve the public interest (through cost reductions and greater efficiency)

11. Research opportunities #1 Quantifying the error inherent in pension liabilityroll-forward processes

12. Roll-forward – what is it? • A simplified mathematical model designed as a substitute for performing an accurate valuation of pension scheme liabilities • A practical response to time and cost constraints • Greatly simplifies data requirements • Quicker to run • Less skilled operators required • Routinely used for the majority of financial reporting exercises (FRS17 & IAS19) in both public and private sectors

13. Roll-forward – what are the issues? • No-one has any real understanding of the magnitude of error inherent in the process • Auditors routinely ask questions about the size of the potential error but place reliance on response from actuary • Actuaries tend to be circumspect in their answers • No real tools or techniques exist to identify the conditions that give rise to errors and potential magnitude • The risk is that there may be material misstatement of pensions figures going into accounts

14. Roll-forward – research linked to the LGPS • The LGPS presents a unique opportunity for a statistically based study into roll forward methodology • We estimate there are around 6,000 LGPS employers that currently report under FRS17 & IAS19 • All FRS17 and IAS19 data exists in the public domain and may also be obtained from Whole of Government Accounts • Accurate results also exist as they are produced for the funds every 3 years for reporting under IAS26 • Regression models could be developed that attempt to explain the link between employer and data characteristics and the observed level of reporting error

15. Roll-forward research – who benefits? • Potentially of significant value to the major audit firms – better placed to insist on full valuations – more accurate financial reporting • Actuarial firms unlikely to complain – more work! • Investors and users of accounts can have greater confidence in the reliability of pensions information

16. Research opportunities #2 Quantifying the error from using index returns in place of actual investment returns

17. Index returns – the issue • Index-based estimated returns are frequently used when actual investment data is not available • Common situations include bulk transfers, financial reporting, interim valuations and in calculating new employer contribution rates • The approach has very simple data requirements (split portfolio into major asset classes, multiply by index-based returns, add up to get total estimated return) • Almost invariably, index returns do not match the actual data when it eventually becomes available

18. Index returns – potential research • Statistical based studies or theoretical treatment possible • Vast amounts of potential data available to generate actual vs expected data • Actuarial firms could be interviewed to understand approaches • Can a link be established between the data, fund or asset characteristics that helps to quantify and explain the potential errors? • Can better models be constructed and tested in the light of this research?

19. Index returns – who benefits? • Likely to be of interest to actuarial and audit firms • Better estimation models will improve accuracy in financial reporting • Auditors will be better positioned to know when estimation techniques will be acceptable or will be better able to understand the potential error

20. Research opportunities #3 Yield curves and the derivation of FRS17 & IAS19 discount rates

21. FRS17 and IAS19 discount rates • FRS17 requires use of a discount rate based on AA-rated corporate bonds of equivalent term and currency to the pension liabilities • IAS19 requires use of high quality corporate bond yields • In practice most firms use the same approach for both standards • In the early days of the standards the use of a single index figure was commonplace (e.g. iBoxx AA indices) • Larger firms now moved away from this and most use proprietary yield curves • Audit firms appear to favour this approach

22. Yield curve research – the problem • The principal problem is that the duration of liabilities for most pension schemes is higher than the duration of the bonds on which the curves are based Responses • Ignore issue and continue to use a simple index figure • Curve fitting models developed using extrapolation • Pragmatic solutions based on the gilts curve (does extend to the required durations) • Subjective individual “judgement” applied

23. Yield curves research – possibilities • A research paper on various curve fitting methodologies, their behaviour under different financial conditions and practical implications for discount rates • Research into the relationship between gilts and corporate bonds (credit spreads) and the potential family of curves that could be derived from using the gilts curve as a base • Development of a high quality open source yield curve model based on publicly available data for use as a reference source for actuarial firms and auditors

24. Yield curve research – who benefits? • Reduced cost to industry as numerous proprietary models likely to become defunct if a free alternative exists • Potential for greater consistency in financial reporting (one of original purposes of the standards) • If offered as open-source there is a significant opportunity for the University to raise its profile within the industry

25. Research opportunities #4 The construction and design ofproxy mortality tables

26. Proxy mortality tables – the issue • LGPS funds are big enough to generate their own statistically significant mortality data • Historically, scheme specific QX tables have been constructed and expressed as adjustments to standard CMIB tables (standard industry practice) • In recent years we have seen the emergence of proprietary mortality tables, usually postcode-based • Very little information regarding these tables is available to auditors and third-party providers of actuarial services • Lack of transparency undermines confidence and leads to higher costs

27. Proxy mortality tables – research • Objective would be to develop an optimising algorithm that, for a given set of data points (usually life expectancies at set ages) leads to a best fit curve with desirable characteristics in relation to a supplied set of input reference curves • Output in the form of industry-standard adjustments to standard tables

28. Proxy mortality tables – who benefits? • Impact on auditors and third-party suppliers is minimised, leading to reduced costs and time in preparing work • Easier for third parties to manipulate valuation results for other purposes if proxy tables can be identified quickly

29. Thank you Questions